Shedding Light on Shadow Banking

Posted in Finance Articles, Total Reads: 2626
, Published on 28 October 2014

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If it looks like a crow, acts like a crow and is hatched in a crow’s nest- is not always a crow, sometimes it is a cuckoo bird. A financial institute that accepts deposits and lends further like a bank is not always a bank- it is a shadow bank.

Coinage of the term:

Though Paul McCulley coined this term in 2007 but it seems 2008 financial crisis answers all “financial evils” of the world. Shadow banking term is also attributed to global crisis due to “Securitization” represented as:

To simplify, say a retail bank has given a housing loan of Rs. 100 to 10 customers @ 10% interest rate with house as collateral. Investment banker buys all the mortgages of the banks and divides the pool into 100 parts of Re. 1 and promises to pay 9% interest rate. The bonds sold are called MBS or mortgage based security and process is called Securitization.

This created an oversupply of house and hence subprime lending started who eventually defaulted. A Housing bubble was said to be created- Will the bubble burst or will it have a safe landing? Bubble did burst- it always does. And the “Shadow” came into light.

Lack of transparency in their operation and a slack in the regulation under central banks gives a way to evade tighter banking norms and regulation and earn higher profit. It also provides quick credit, assist regular Banking system through range of services like Auto loan, Insurance, Housing loan, Gold loan, and Stock broking but due to its interconnectedness with banking system, it poses a risk systemic in nature. Risk can be of direct or indirect in nature:

Direct Risk:

Shadow Banks don’t have collaterals like CRR, SLR and also don’t enjoy recovery powers under SARFAESI act. So in case of any collapse, it is certainly not going alone.

If banks give credit line to these Shadow banks or latter deposits in Banks, in both the cases Bank experiences a great amount of exposure. E.g. Malaysia, NBFIs deposits account for 10% of total bank deposits while bank lending to NBFIs is 3% of total outstanding loans.

Indirect Risk:

Many a times both operate in the same sector or deal with the same set of clients both in asset and liabilities side. Fall of shadow bank will send ripples across to the economy through the banking system.

Apart from these it also faces liquidity risk, leverage risk and risk of “run”. Liquidity risk can be attributed to maturity transformation and absence of funding facilities like repo. Leverage and risk of “run” is because of the absence of regulation on borrowing, lending and collaterals. These risks amount to default risk, recent Chinese shadow bank default of nearly 3 billion Yuan is one such example.

High presence of shadow banking system in countries like Netherlands, US, Hong Kong and EU poses a risk of systemic risk. In India, Shadow banks account for 21% of the GDP compared to bank assets which are 86% of the GDP. Their activities are limited and also regulated to mitigate the risk of any global financial crisis.

It is synonymous to NBFCs in India but all of them are not regulated by RBI alone. For example, an Insurance company like LIC is regulated by IRDA.

SEBI is the regulatory body for underwriting companies and stock broker companies like Indiabulls. Notorious Chit Funds comes under State government’s registrar.

Unlike the mammoth size of shadow banks in US and EU, which was directly responsible for global financial crisis and PIGS crisis in Europe; India’s Shadow banking system is not large enough to cause such distress. But its potential in Indian context can’t be undermined as one of the fastest growing sectors:

With such a growth it pours liquidity outside the official system and makes it harder for RBI to control its economy. The inflation rate stayed higher than 8% despite 13 times rate hikes by the RBI in two years.

Despite these, nearly 80% of the NBFCs have a CRISIL rating of AA or above i.e. it has negligible chance of causing systemic risk.

It has been able to penetrate into geographies through micro financing, Business correspondents and door-to-door service which are impossible for banking system to get into.

Unlike PSUs of India like SBI which are not only “Too big to fail” but “To big to bail” also; NBFCs are entrepreneur driven and quick to react. Most of the largest NPAs are held by these large PSUs and not NBFCs.

Conclusion:

Why government doesn’t take the control of this rouge Shadow banking system?

Lobbying in the western economy helps it keeps afloat. In India it finances small business which forms the backbone of the economy. It also provides the much needed “financial inclusion” to rural India.

Nachiket Mor committee report speaks about convergence of Banks and NBFCs. It recommends Universal electronic bank account, access to bank services and customer protection. Institutional framework and regulation are based on the four yardsticks of stability from systemic risk, transparency of financial data, neutrality towards participants and responsible to customers. Recommendations look robust; key is to see how many of them are implemented by RBI.

Its growth guarantees more financial participation but at the same time increases the risk. So the challenge is to make this regulated without hampering its swiftness to provide quick credit, lean and efficient functioning.

A Word of caution with shadow banking- “even your shadow leaves you when you are in darkness”

This article has been authored by Avnish Kumar and Mitesh Kumar from TAPMI